One of the most powerful indicators that you can add to your lineup of technical tools is the Average True Range indicator or ATR.
It will provide you a breadth of insight into the asset you're trading.
But what exactly is it?
How do you use it?
Well, this article will explain what is the average true range indicator, how it's calculated and its uses.
What is the ATR?
The ATR is an indicator developed by J. Welles Wilder.
It was first mentioned in Wilder's 1978 book New Concepts in Technical Analysis Systems.
In other words, the ATR won't tell you if an asset is overbought or oversold or if it's on an uptrend or downtrend and where it's heading to.
The indicator simply gauges market volatility but also serves several purposes for traders.
Now, before learning about the different ways to use the ATR, it's essential to understand how the ATR is calculated or at least what comprises its formula.
ATR makes use of the highs and lows of prices, or in other words, an asset's trading range, but not just that, the ATR also accounts for gaps, which the trading range fails to capture.
The gaps or the "missing volatility" that the ATR includes in its calculation provide a complete view of how an asset is trading, and that is what Wilder referred to as "True Range" (TR).
There are three methods for calculating the True Range:
Method 1: Current high less the current low
Method 2: Current high less the previous close
Method 3: Current low less the previous close
Then, whichever gives the highest value among the three methods will tally in the average (disregarding negative values since the calculation only accounts for the absolute value).
A smoothing factor is also applied to the average to put more weight on the latest data.
Current ATR = ((Prior ATR x 13) + Current TR) / 14
Here's a short video on how to calculate the ATR using Excel:
Using The Average True Range
Now, as mentioned, ATR's primary purpose is to measure the volatility of an asset.
The TR is plotted using a continuous line, and the number on the graph represents the average price value in the 14 days that the asset has moved.
When that line rises, that means that volatility has increased and vice versa.
Now, recognition of an asset's volatility helps a trader see how it has traded recently and what trading setups can be made from a period of low and high volatility.
But the ATR has other uses, and these include:
1. Setting Profit Targets
Since the value on the graph represents the average change of an asset's price during a particular timeframe, you could assume that there's a good chance that the asset will not divert so much from the ATR value; thus, the ATR reading presents as a likely profit target.
For example, you're planning to buy the GBP/USD at 1.2850, and the ATR is showing a reading of 0.0078.
You could assume that if your analysis supports a long position right now for GBP/USD, your target would be 0.0078 or 78 pips to the upside.
This means that you'd set your eyes on 1.2928 (1.2850 + 0.0078 = 1.2928).
Look at the example below:
On this particular trade (from the chart above), the ATR functioned as a profit target.
The sell signal for this trade was triggered by the small green candle on 1.0620, which is on the nose of the 50-day moving average.
The rationale for the trade is the technical bias still tilting to the downside, so the two-candle retracement served as an entry for a short position.
A total of 58 pips was the set target, and this was primarily based on the ATR value (no multiples although it can be applied), and the risk target, since it was very close to the resistance level created by the MA, was, at least, half of the ATR at 25 to keep a favorable reward to risk ratio.
The trade worked out well, and the take profit order was hit before the price broke past the 50-day MA after the fourth day.
2. Stop-loss Levels and Trailing Stop
Aside from profit targets, the Average True Range indicator can also be used as stop-loss levels.
It works the same way as setting profit targets, but this time it's on the opposite side of the intended direction of your trade.
One thing to note about stop-loss levels using ATR is that some traders use twice the ATR value (sometimes even in multiples of three or four).
The purpose of this is to use the trading range suggested by the ATR but twice its value to add some cushion to your trade.
ATR Trailing Stop
Now, once a stop-loss is set, and the trade moves in your favor, what you can do to implement a trailing stop is to continue to inch your stop-loss level at a value doubling (depending upon the multiple you've chosen) the ATR reading and below or above the current trading price (depending upon your trade).
3. Confirm a support and resistance breakout
A break in support and resistance is critical nonetheless, especially with the confirmation of an uptick in volume.
But another way to confirm the breakout is with the ATR.
When a high ATR reading supports a breakout, it could help confirm that the price's new move is there to continue.
Here's an example of how the ATR spotted a false breakout:
The shooting star's presence on the 1.0878 resistance makes a tempting sell but not because of the technical bias favoring it -- in fact, the resistance level created by the two moving averages has been obliterated by several candles back -- but because the breakout wasn't supported by high volatility from the ATR reading.
A sell trade again was taken with 59 pips as the target, and 25 pips as stop-loss and the profit target was acquired by the second day.
And here's how it's used for confirming an actual breakout to the upside:
Above the 1.0878, you can see that volatility has increased significantly as the ATR now shows a 74 pip reading, an increase from 59.
The breakout above 1.0966 that's supported by the ATR shows that the currency pairs downturn is on the verge of getting flipped, the two moving averages are also converging and are ready to print the golden cross signal.
Although there was a slight pullback as sellers enter the scene, the bullish momentum continued after five days of selling and went on to trade above 1.1100.
Multi-year ATR value
A strong breakout can also occur during periods of very low volatility, and you can see this from a low multi-year ATR value.
When the ATR reading for an asset drops to a multi-year low from the weekly or monthly timeframe, it can be indicative that a powerful breakout is on the horizon.